Behavioral Economics and the Conservative Critique of VAT

By :: October 28th, 2009

Our grim fiscal outlook has led to renewed calls for a value added tax (VAT). As discussed by Greg Mankiw, conservatives have conflicting feelings about a VAT. The main appeal is that a VAT taxes consumption, so shifting from our current income tax system (which is actually a hybrid of an income tax and a consumption tax) to a VAT would remove existing disincentives to save, which in turn would promote long-term economic growth. 

Yet many conservatives fear that a VAT, which taxes each stage of production, will lead to bigger government. As Milton Friedman wrote in 1980, “Because it would be collected by business enterprises, VAT would be concealed in the total price the consumer paid and hence not perceived as a direct tax burden. That is its advantage to legislators – and its major defect to the taxpayers.”

Friedman’s concern is now very much at the center of the new field of behavioral public finance. In the most recent edition of the American Economic Review, Raj Chetty, Adam Looney, and Kory Kroft, examine the effect of tax transparency – what economists call salience – on economic efficiency. 

Traditionally, economists view the structure and application of a tax as unimportant. All that matters is the change in relative prices. But Chetty, Looney, and Kroft find that structure and application do matter. For example, they find that consumers are less likely to buy an item if a sales tax is explicitly listed on the product than if the same tax is instead added at check-out. 

This simple finding has great political economy implications. With the traditional view that the magnitude of the tax is all that matters, the left/right debate among economists has focused on how responsive people are to a given tax. For example, would taxing labor lead to a small or large reduction in hours worked? The bigger the response, the more economically harmful the tax. But the new behavioral studies suggest that policymakers can actually manipulate the reaction to a tax. By making a tax less transparent, policymakers can trick consumers or workers into non-response, thus reducing the economic harm.

Chetty, Looney, and Kroft’s theoretical model indeed shows that efficiency increases as a tax becomes less salient. However, their model also shows that reducing the salience of a tax will necessarily harm consumers (albeit not by as much as it helps the government). In other words, tricking consumers into thinking a tax does not exist has two effects: 1) it leads them to poor consumption choices; and 2) it increases tax revenue because more transactions are taxed. In dollar terms, the harm to consumers is less than the increase in revenues. But whether or not you view an opaque tax as a useful policy instrument depends on whether you think the gains to government coffers are worth the reductions in consumer welfare. 

As Friedman feared, government can go a step further. If complicated and opaque taxes can dull consumer response, they can also dull the political penalty associated with higher tax rates. An optimizing government could then increase tax rates by more than fully-informed voters would like. Amy Finkelstein, in the most recent edition of the Quarterly Journal of Economics, finds that drivers are less aware of tolls paid electronically and that switching from toll booths to electronic tolls led to a 20 to 40 percent rate increase. In other words, as salience goes down, tax rates go up.

The flourishing field of behavioral economics is improving our understanding of how psychological factors influence economic responses. But the risk is that policymakers will use these insights to deliberately temper healthy economic and political constraints on the growth of government. 

3Comments

  1. Anonymous  ::  5:45 pm on October 28th, 2009:

    As you say, the income tax is part consumption tax, albeit an invisible part at the register. This is especially the case where employers pay the tax at withholding – making the annual filing ritual a reporting event rather than a payment event for most people.
    Whether it is best to make the tax more visible at the register depends on how you do it. Given that 40% of earners pay no taxes at all, some form of consumption tax will be healthy, even if there are adequate refunds or subsidies to make the effect zero.
    I propose, as most of you have already seen, establishing a VAT for domestic military and civil discretionary spending while retaining a business income tax for family tax credits and other entitlements(like health care reform), replacing low rate income taxes (and the lower 25% of the 28%+ rates), payroll taxes, corporate income taxes and individual tax filing of business expenses. The residual income surtax will range from 3% (28% rate – 25%) to 14.6% (or 19.6%, if the House surtax is enacted for health care reform). The surtax would cover overseas and sea military deployments, net interest, debt repayment (including the FICA Trust fund) and foreign operations (including WB/IMF bad debt forgiveness). The surtax would sunset when there are no more deployments or debt (including that held by FICA and the Fed).
    If the behavioral economists are correct, this would allow entitlements to increase to sufficiency and cut discretionary spending – most especially pork.
    I have been posting this option for a while. It would be nice if the TPC would score it. My question is, what does someone have to do to get their tax plans scored?

  2. Anonymous  ::  10:34 pm on November 3rd, 2009:

    Regarding the Milton Friedman quote — while there is an ounce of truth to it (yes, VAT is factored into the final retail price) that hardly seems like a legitimate argument against VAT.
    I have no objection to the line of reasoning that hidden taxes are particularly onerous — the public cannot object to what they don't perceive. But let's be honest; it's painfully obvious to consumers when they're paying VAT. Just ask any European. Every German resident whom I know understands perfectly well that each purchase is subject to a 19% VAT.
    Consumers eventually become quite adept at calculating what the pre-VAT price would have been — much in the same way any waitress can figure out a nice tip without reaching for a calculator. People CAN do math. The VAT is hardly a 'hidden' tax.
    No disrespect to Uncle Milton, but you've got to do better than that. If anything, conservatives should embrace the VAT. It's a regressive consumption tax. What's not to like?
    Robert Goulder
    Tax Analysts

  3. Anonymous  ::  8:13 am on May 5th, 2010:

    Taxes are really a burden. It has now become an ordinary deal to compute the weight of the VAT when calculating consumer products. However, it still doesn't change the fact that VAT really increased the burden on taxpayers. Apart from the income tax, there's added VAT to everything else they buy. Just hope this added amount goes into the right places.
    Drainage Problems